When Records Prove Elusive -- Part II

JUST HOW BAD IS THE PRIME beef shortage? Tales abound of cattlemen bringing cattle to slaughter earlier. New York's legendary Peter Luger Steak House, for instance, is cutting back reservations and booking fewer big parties. The ever-so-helpful New York Times last week suggested "less luxurious cuts" for the grill this weekend (skirt steak, anyone?).

Several things must happen before steakhouses rebound. Rising beef costs must moderate, and you'd catch the first whiff of that in cattle futures. Consumer spending should improve as the housing market stabilizes and as gas prices drop, but these will likely be signaled by an upturn in retailers' forecast.

Until then, steakhouses can hike prices (and risk losing customers), or swallow the higher costs (and risk losing profits). Stockholders can hope for buyout offers, like those for
Smith & Wollensky
(SWRG) and
OSI Restaurant
(OSI). And management will bravely talk up expanded "menu alternatives," even as chicken and pork prices climb. But let's face it: When it says "Steakhouse" in your name, the lobster ravioli, no matter how stellar, can only disappoint the carnivores.

Shares of the online option brokerage (OXPS) have skidded more than 20% since November, even as the broad market surged and as U.S. option-trading volume expanded. By targeting individuals who want to trade options, the Chicago firm helped drive the option boom, and Wall Street salivated over its impressive results: More than 204,600 customer accounts in 2006 (up from 22,171 in 2002), and compound annual growth rates of 81% for revenue and 101% for net income. A 48% return on equity last year was three times that for the median S&P 500 company.

Lately, however, the murmur on OptionsXpress has grown dark and ominous. Success has invited competition from both upstarts and larger firms muscling in on its turf, making it tougher to snag new customers. The cost of attracting each new account had more than doubled over the past year to $350. And as the U.S. contemplates trading options in penny increments, exchanges and market makers squeezed by narrower spreads are threatening to cut back on payments to brokerages for steering customer orders their way. These kickbacks, called "payment for order flow," make up 15% of OptionsXpress' revenue.

Sensing the end of the line, growth investors have disembarked, and OptionsXpress might have continued its slide if not for a whiff of takeover speculation last week. Shares popped, and call options on the option brokerage traded briskly.

Little heed should be paid to such chatter, but there are reasons why speculation has struck a chord. OptionsXpress is a recognizable brand in a coveted niche. At 15 times forward earnings, the stock also is cheap for a company with pretax margins of 64%. It is also efficiently run, with revenue per employee topping $1 million last year, compared with an average of $463,000 for peers including
Ameritrade
(AMTD),
E-Trade Financial
(ETFC) and
Charles Schwab
(SCHW). A pristine balance sheet with no debt and more than $7-a-share in cash further accentuates its allure.

At 24.75, potentially slower growth also seems factored into its stock price, and escalating advertising costs are still well below the industry average. Each new account generates more than $650 in annual pretax revenue, and for years to come (since its customer defection rate is only about 5% or 6%).

Fallout from penny-trading also may be over-estimated. OptionsXpress saw a 5% decline in payments when exchanges recently began testing penny-trading in a limited pilot program. But it has since recovered "most of that decline" after market makers saw their profits haven't vanished, says OptionsXpress president David Fisher. "Quoting options in pennies doesn't eliminate the inherent value of our order flow," he tells Barron's. "In fact, it makes it more important for some market makers to interact with our retail order flow."

As the firm expands, the percentage of revenue from such payments has also decreased. Even if penny trading soon becomes reality, any payment declines may be offset by increased trading volume.

A recent acquisition of XpressTrade also helps OptionsXpress push further into futures and foreign exchange trading. And while
Goldman Sachs
(GS) previously cleared its trades, a recent conversion to self-clearing should trim expenses.

OptionsXpress also has exported its early-mover edge in the U.S. to Australia, Canada, Singapore and Europe. Fisher would not break out overseas data but says its international business is growing faster than the U.S., albeit from a smaller base. Earlier this year, I snuck into one of its seminars in Singapore and was struck by what I saw: hundreds, having braved an ungodly tropical monsoon, crowding into an auditorium on a weeknight to learn how to trade U.S. options.

Sure, management must find new ways to win customers and trim marketing costs. It must continue to improve technology. But in a consolidating industry, OptionsXpress has a big leg up, since its customers are more affluent and trade far more actively. Another bonus: options expire every month, so even the most conservative covered-call writer will trade again and again. For bigger brokerages lacking an option platform, that's a recurring dream come true.

SPEAKING OF OPTIONS, HERE'S A HANDY STRATEGY with stocks straining at record peaks. "Collars" allow conservative investors to participate in rallies up to a certain target but limit downside risk should the market slide. You accomplish this by selling out-of-the-money calls and using the proceeds to buy protective puts, so collars require little or no out-of-pocket expense.

Given the market's upward bias, call prices have become rich. And collars "are most attractive when potential gains under the collar substantially exceed potential losses," says Thomas Schwab of Summit Portfolio Advisors.

Take the upwardly mobile
Apple
(AAPL), for example. With shares near 112.50, selling a 130-strike call that expires January 2009 can generate enough to buy a 110-strike put of similar duration. That allows investors to participate in a rally up to 130 but protects against declines below 110 -- or a potential annualized gain of 17.7% with potential downside of just 0.4% (thanks to a slight credit from the collar).

Schwab screened for other stocks with lopsided call-to-put prices. An
Amgen
(AMGN) collar, for instance, allows potential gains of 29% versus downside risk of 8%, while
Newmont Mining
(NEM) has potential upside of 30% with 9% downside. The list includes rallying stocks like
Franklin Resources
(BEN) and
ConocoPhillips
(COP), as well as declining ones where the option market seems to be eyeing a rebound, like
Limited
(LTD) and Newmont.

Collars are also useful for hedging broader portfolios. With the
S&P Depositary Receipts
(SPY) near 152, selling 175-strike calls that expire December 2008 will buy 135-strike puts, leaving room for an annualized gain of 10% with 5% downside risk. Here, the upward pricing slant still works in your favor but is less lopsided, since broad-market puts already are in heavier demand.

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